The money raised by private equity funds in emerging markets dropped by almost a third last year – but according to one of the leading investors in the field, market-beating returns are still on offer, as long as you work for them.

Institutional investors, such as pension funds and wealth funds, invested $61 billion into private equity funds in emerging markets last year, according to data providers Preqin – a marked dip compared with the $87 billion a year recorded in 2012 and 2011. Sentiment is likely to have been hit by lower growth expectations in developing economies, coupled with a sell-off in these countries’ public markets last year.

But while fundraising may have dipped, the basic investment case remains sound, according to David Wilton, chief investment officer for private equity funds at the International Finance Corporation – the commercial arm of the World Bank. He manages a $3.5 billion private equity portfolio and invests up to $500 million in 20 to 25 emerging-market funds a year.

He said: “In Europe and the US, it is a leveraged buyout model, which is very exposed to macro shocks, as we saw during the financial crisis. Emerging markets private equity has much more opportunity and execution risk because it’s growth equity.”

The IFC has been investing in this area since the 1990s, but Wilton took over in 2000. He presented the organisation’s results, and gave his expectations for the future, at a conference in Hong Kong organised by the World Pensions Council in November.

The IFC’s portfolio has generated an internal rate of return of 18.3% a year between the start of 2000 and June 2013. That compares with a 9.6% return for the average fund in Cambridge Associates’ table of emerging-market private equity funds and 8.9% a year for the MSCI Emerging Markets index.

Wilton says there are reasons to believe private equity funds will continue to outperform in these markets. He said they invested more in companies that were expected to do well from the rise of middle-class consumers compared with emerging-market equity indices, which are more heavily exposed to energy and finance.

Headwinds

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Despite his bullish stance, Wilton does expect challenges for private-equity investors in these markets. He said: “In the 1990s, there was a huge amount of deregulation, leading to much more favourable business opportunities. The good news is people are still deregulating but it’s more gradual now. The opportunity is now maturing.

“That means many companies are moving from rapid early-stage revenue growth to shallower later-stage growth. Managers will have to focus more on inorganic growth, through mergers and acquisitions or greater efficiency.”

In turn, that means the IFC is asking its private-equity managers to show they have the expertise to pursue such strategies with portfolio companies. Wilton said: “Our managers are making this transition, adding the people with those skills, so I am still optimistic that I can deliver 20% net to investors – but it’s a much more hardworking environment.”

And while investment into emerging-market private equity funds is down overall, the potential remains for overcrowding in some places. Wilton said: “My fear is that the next place the lemmings will run to is Africa. They did it before with Brazil. At the top end of the market it will get overcrowded.”

First-mover advantage

Wilton says the IFC’s strong results come principally from picking the right funds and managers, rather than from geographic allocations – though his portfolio has a marked bias away from Asia, compared with the Cambridge index, with a greater allocation to Africa.

But one of its chief advantages is its use of first-time fundraisers, he said: “Our due diligence template does not focus on track records, because 50% of our funds are first-time teams.

“The internal rate of return on the total portfolio is 19% a year, but for the first-time funds, it’s 25% a year. In the US and Europe, first-time funds are seen as very risky. But if you are raising the first fund in a given country, you have little competition for deals.”

He concedes most institutional investors cannot replicate the IFC’s model: “I have 30 staff covering the globe, and that is difficult to duplicate”. But he said there are lessons that other investors can learn – keeping allocations small and considering first-time funds.

He said: “I think that if your bite-size [the amount you can invest] is between $20 million and $50 million you can focus on the mid-market – the funds between $200 million and $400 million in size. Then the world is your oyster. On manager selection, we have adapted our template to cope with first-time funds. Others can too.”

He advises focusing less on performance records, which newer teams obviously do not have, and instead asking questions about expected dealflow, macro and political risks, and the team’s experience and local knowledge.

Nevertheless, mainstream institutional investors and consultants are likely to remain cautious. Olivier Cassin, managing director at consultancy Bfinance, said: “We are always cautious when it comes to private-equity investing in emerging markets. We see the market maturing, and [managers launching] second- and third-time funds, particularly in Asia. But we are wary of the high dispersion of returns and the risks compared with the US and Europe. It is not clear yet that investors are remunerated for the extra risk.”

--This article first appeared in the print edition of Financial News dated January 13, 2014